Is quantitative easing really inflationary?

On numerous occasions you will have heard me use the term ‘monetizing debt’ to describe what happens when the central bank creates money out of thin air in order to increase reserves in the banking system. The central bank is certainly increasing the monetary base in this regard, but are they really monetizing the debt being issued by the federal government? Let’s examine the issue to find out.

Fiscal and Monetary Authority

The crux of the issue here is whether the US or the UK central governments can deficit spend to their hearts’ content in order to prop up their respective domestic economies and whether this spending will be financed by printing money at the central bank.

In both cases, a small budget deficit in good times has turned into monstrous deficit reaching double digits in percentage terms. Moreover, the two countries have a monetary authority (the central bank) and a fiscal authority/backer of legal tender (central government) which is at the same level. This is not true in, say, Spain, where the ECB and the Spanish central government are at different levels.

So what happens then?

Printing money

Let’s first turn to the central bank. The central bank, looking to increase bank reserves in the system, buys assets (usually federal government debt) with previously non-existent money that it electronically prints out of thin air. This money printing is known as quantitative easing or QE. QE increases bank reserves in the system when the seller of the assets deposits the new funds at her bank and the bank then holds some of these funds in reserve at the central bank as it is mandated to do.

The hope is that the seller’s bank will then go out and lend the non-mandated funds, thus increasing credit in the system. However, what has generally happened is that the bank has deposited these funds at the central bank as excess reserves without lending it out, receiving only the base rate of interest for doing so – almost zero.

The reason excess reserves are piling up in the UK and the US has as much to do with the demand for credit as it does with the impairment of banks’ balance sheets. Banks are under-capitalized on a mark-to-market basis, and are, therefore fearful of making new loans when they need to increase their capital base. But, companies and individual, fearful of their enormous debt burdens in a world of asset price deflation, show no demand for credit. The lack of credit and the build-up of excess reserves is, therefore, due to constraints on both the supply and demand sides of the credit process.

But, this is a situation which cannot continue ad infinitum because those reserves are assets on the bank’s balance sheet earning near zero interest. That means the bank’s profitability is lower than it would be had it lent out those funds or purchased assets with those reserves. Right now, that is acceptable because banks are earning a lot of cash due to high interest spreads, but eventually, these excess reserves are going to become painfully unprofitable.

So, eventually, the bank will be forced to buy some treasuries in order to increase profitability. Obviously, treasuries would be the asset class of choice for financial institutions fearful of making loans while their capital base is impaired. This makes those lenders wiling buyers of federal government debt and financiers of the burgeoning supply of the government’s spending spree. In essence, the central bank has caused the private sector to prefer bonds over reserves by pushing the overnight rate to zero. That is what is meant by monetizing debt.

Whether the seller is domestic or foreign, the net effect is the same in increasing reserves unless a foreign seller converts the money into a foreign currency without eventual re-conversion back into the domestic currency. In this case, QE has actually increased reserves in the foreign baking system instead.

By the way, monetizing debt is a central issue in the debate over Federal Reserve independence. Because the Federal Reserve has been acting in concert with the executive branch since the credit crisis began, many are beginning to question its quasi-fiscal role in supporting the wider financial system with bailouts, subsidized borrowing, guarantees and liquidity. Add in the QE and a ballooning Fed balance sheet as the central government deficit spends and you have an organization that seems to be acting on behalf of the executive branch.

Is this inflationary?

It all depends on net private savings as to whether this stokes inflation in the short-term. The reason that the Federal Government is deficit spending to begin with has to do with the loss of consumption in the private sector due to increased deleveraging and savings. In the U.S., we have seen the savings rate rise from negative territory (i.e. saving nothing and spending even more by drawing down accumulated wealth) to almost 7% in a few years’ time. This behavorial change is a positive for America as it is a recognition of the excess consumption that an asset-based economy created. It puts America in a much better position on its current account and helps to reduce debt from unsustainable levels.

But, it is also responsible for much of the decline in the US economy. So, to prevent a deflationary spiral, the federal government has stepped in to fill the void. But, if the increase in net government spending (with the improvement in the current account balance) is less than the increase in net private consumption (both via individuals through lower consumption and companies through reduced capital spending), then the net effect of the spending will not be inflationary. In that case, the net consumption of individuals, businesses and government (C + I + G +(EX-IM) for you economics fans) is lower than it was before the negative consumption shock.

Over the longer-term, the money printing is problematic. When demand for borrowing is restored, the extra reserves in the system will be lent out. Moreover, the excess reserves can always be invested in higher yielding assets by the banks in order to increase profitability. Therefore, this sequence will engender rises in either asset or consumer prices, depending on how much excess capacity is in the system. This is why it is imperative that the Fed outline how it plans to withdraw all of the excess liquidity it created when it expanded its balance sheet by twofold.

And since capacity utilization is incredibly low right now, my bet is on asset price inflation rather than consumer price inflation. So when Marc Faber says don’t underestimate the power of printing money, this is what he means. That is how and why an asset bubble can inflate even in the face of poor fundamentals and why the present bear market rally can sustain itself longer than one might think. Eventually, all of this comes to an end and the fundamentals re-assert themselves. When that is, is the $23.7 trillion question.

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He has also been a regular economic and financial commentator in print and on television for the past decade. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.

To the extent that the deficit is increasing due to decreased tax revenues – then government spending isn’t increasing. The purchase of treasuries by banks funded from the Fed fills the tax revenue shortfall.

In this crisis, the classic Keynesian government spend has been outsourced. The banks have been selected to be the “spender of last resort”. The government will be frustrated in attempts to produce real increases in spending – debt limits are being reached and it is going to be difficult enough to roll over what is already in place.

So, is this inflationary?

Maybe the question isn’t inflationary as much as when inflationary and under what conditions? Now the banks hold the keys to determining when and how to inflate. They can influence the inflation of asset values, but could continue to constraint consumer debt.

The idea that the Fed will be able to withdraw liquidity is based on an assumption that an inflated economy will correspond with increased economic activity and an increase in income. If that fails to occur then withdrawing liquidity will crater the system.

Of course, a circulation flow can be built where the banks return funds to the Fed, then access funds through different programs – we called it check kiting when applied to consumers. So, there is the appearance of transactional flow, but it does nothing to increase incomes and therefore spending.

If inflation is defined as a real increase in wages, then this is an anti-inflationary approach. If inflation is defined as a real increase in consumer prices in relation to income, then it is an inflationary scenario, as prices can remain stable or even decline while incomes can decline faster.

DavidPearson says 11 years ago

A related question: “Is QE stimulative?”

You see, by saying QE is not inflationary because it hasn’t been spent/lent, then you’re also saying QE is not stimulative for the same reason.

Yet Bernanke said today that monetary policy is “highly accomodative”. Accommodative of what? Banks’ desire to hold higher cash levels? Certainly. The need to raise aggregate demand in the aftermath of a deflationary shock? Nope.

The Fed has led us to believe that: 1) they have stimulated the economy; and 2) we don’t have to worry about inflation because the stimulus was never spent.